For the second time in its short but eventful history, the US technology sector has been booming. Will there be another bust? We think growth in the sector is here to stay, but vigilance is required as some valuations start to defy gravity.
At its recent peak, the sector had a cumulative market capitalisation of a little over $5 trillion, higher than the peak of the previous tech boom. It represented just under a quarter of the entire S&P 500, with the five biggest US companies all technology stocks — Apple, Alphabet (the holding company for Google), Microsoft, Amazon and Facebook — together making up 13% of the index (figure 1). Three of these companies did not exist 25 years ago.
Some valuations in the sector are reaching dizzying heights, reminiscent of the 2000 tech boom that went bust. For example, Amazon is up more than 150-fold from the low it reached in 2001 when technology hype had morphed into despair, and now trades at 112 times consensus forecasts for earnings over the next 12 months (the forward price-earnings, or PE, ratio). That compares with an average forward PE of 17.7 for all companies in the index (figure 2).
Over the past 12 months, these big five technology stocks have returned an average of 39%, more than doubling the overall market’s increase of 19%. Over the past five years, they have returned an average of 252% compared with the S&P 500’s 101%. (We focus on US technology stocks here because they are generally the biggest in the world, and technology now represents only 1% of the UK market.)
Figure 1: The famous five The five largest US technology stocks make up 13% of the S&P 500 Index
Pause for breath?
After such strong performance, the technology sector may be due a pause or correction as investors take profits and reassess the upside from here. It has benefited from declining government bond yields, which have the effect of boosting what investors are willing to pay for the future cash flows of growth companies. So a rebound in bond yields could also cause pressure. But could we see a more damaging and long-lasting reassessment of their value?
In the technology boom of the late 1990s and the first part of the year 2000, investors became carried away with fanciful projections of how companies might harness the new medium of the internet in order to drive future profit growth. But in many cases there was little hard evidence for this optimism. The internet was novel and quickly evolving, and few companies had yet found a way to make money from it. There was also little evidence of who the winners might be — Amazon survived and thrived, but others such as Boo.com quickly fell by the wayside.
Technology companies found it easy to raise new funds and spent prodigiously in order to secure as many users as possible. Valuations also became very stretched. The five biggest technology companies at the peak of the last tech boom — Microsoft, Cisco, Intel, Oracle and Lucent — had an average forward PE of 74 times. In other words, they were priced to be worth 74 times the next year’s projected profits. And the technology sector had grown to represent 33% of the S&P 500.
When the hype and over-optimism around future profits burst in the second quarter of 2000, the stocks fell heavily from their inflated peaks, exacerbated by a downturn which showed them to be susceptible to economic cycles.
It's a digital life
Today the internet has become well established, evolving to be mobile via smartphones and a daily part of most people’s lives — in the developed world and increasingly the emerging world too. There are a number of distinct segments within technology that are now seen to have different growth characteristics. For example, technology hardware, semiconductors, systems software (such as Oracle) and consulting are in many cases more mature businesses with a degree of cyclicality, while application software companies like Adobe and Salesforce.com are seen as faster growth. The fastest growth of all is coming from internet businesses such as Alphabet, Facebook and Amazon, which derive significant ‘network effects’ from having a large, regular user base.
This diversity within the sector means that the overall valuation is not excessive — the S&P 500 Information Technology subsector trades on a forward PE of 18.4 times, significantly less than the 52 times it reached at the peak of the technology boom, and little more than the 17.7 times the overall S&P 500 commands.
More concern surrounds the biggest five technology names that, as we have seen, now account for nearly 13% of the capitalisation of the US stock market. These five trade on an average forward PE of 40 times, though this is skewed by outlier Amazon. Alphabet trades on 26 times, while Apple trades on around 14. All five generate prodigious free cash flow.
Alphabet and Facebook have been very effective at seizing a large share of the growing online advertising market, accounting for 20.5% of global advertising spend in 2016. Taking current consensus expectations for their future growth, and assuming global advertising growth keeps pace with forecasts for global economic growth of around 3.5% per annum, these two companies alone would represent 37% of global advertising by 2020. This suggests that expectations of their advertising growth may be vulnerable to disappointment. We also need to be mindful that advertising revenues are cyclical — now that internet companies are such important advertising businesses, they may struggle to outgrow any downturn in the advertising cycle.
Diversified revenue streams
The counter-argument is that Alphabet and Facebook are being valued as franchises capable of growing other earnings streams as their advertising revenue growth slows. Alphabet has leveraged the user base and cash flows from its core search business to develop six other businesses, each with more than one billion users, including YouTube, Gmail and Google Maps. It also invests in ‘other bets’ such as driverless car technology, artificial intelligence and home automation. Facebook has developed a global user base of
two billion active monthly users, of whom two-thirds use it daily, a platform that it could potentially use to generate non-advertising revenues. For example, Tencent, the dominant Chinese social media company, makes most of its money by selling online games to its user base.
Some analysts believe Amazon’s relatively stratospheric valuation is justified by its dominance of e-commerce as it moves into more goods and services across more markets. Its investment in these new areas is costly and depresses short-term profitability, but the argument is that once this investment phase stops, Amazon’s profitability could increase substantially, particularly if it succeeds in driving many conventional retail competitors out of business. It also has a fast-growing and high-margin Cloud web services business.
Cash is king
All the big five technology companies have built up significant cash piles — in the case of Apple its cash represents nearly 22% of its market capitalisation. This cash gives them the ability to acquire businesses in order to gain expertise, technology or market positioning to accelerate their growth. Amazon, for example, has just done this by bidding for Whole Foods Market in order to expand its offering in fresh and organic foods. Even more importantly, cash can help them to stifle or co-opt emerging competitors who could potentially disrupt their market position.
The ability to avoid disruption is critical to the value of these businesses, which themselves began as disruptors. Technology is changing ever more rapidly and transforming business models. The current technology leaders must do everything in their power to stay in step with or ahead of new developments, in order to remain relevant to their customers. Otherwise they risk becoming quickly outmoded and going the way of Yahoo! and Nokia.
The technology sector could well pause for breath, or even see a correction following its extended period of outperformance. But we believe it remains a sector that investors need exposure to, given its higher than average growth and the capacity for the businesses within it to benefit from technological change.
Figure 2: Technology in focus This chart shows the PE ratio of technology companies in the S&P 500 Index relative to the total index. Some valuations in the sector may be getting stretched.